Mean reversion is a widely observed phenomenon in financial markets. It refers to the tendency of asset prices to move back towards their long-term average over time, following periods of deviation. This concept is grounded in the idea that markets are cyclical in nature, and that prices can become stretched too far in one direction or the other.

A good analogy for mean reversion is a bouncy ball. When a bouncy ball is dropped from a height, it bounces back up to a certain height that is lower than its original drop point. This is due to the forces of gravity and elasticity, which cause the ball to lose some of its energy with each bounce. Similarly, in the financial markets, asset prices that have moved too far from their long-term average tend to revert to the mean. This is because market participants eventually step in to bring the market back into balance, causing prices to move back towards their long-term average. Just as a bouncy ball eventually returns to its resting state, financial markets tend to return to a state of equilibrium over time.

Market balance is an important aspect of mean reversion. When prices become too high or too low, buyers or sellers will step in to bring the market back into balance. This helps prevent prices from continuing to move in one direction indefinitely, as eventually, the forces of supply and demand will come into equilibrium.

There are many examples of objects in the world that get stretched out and need to come back to the mean. One such example is a rubber band. When a rubber band is stretched too far, it will eventually snap back to its original size. Similarly, in the financial markets, asset prices that have become stretched too far from their long-term average tend to revert to the mean.

However, not all stocks behave the same way. Some stocks can run away from their long-term averages for extended periods, making them dangerous to short even when you think they can’t go any higher. This is especially true for stocks with a lower float, meaning there are fewer shares available for trading. When there is a high demand for a stock with a low float, the price can rise rapidly, making it difficult to short the stock without incurring significant losses.

The float of a stock refers to the number of shares available for trading in the public market. A stock with a small float is more susceptible to large price movements than a stock with a larger float, as there are fewer shares available to absorb buying or selling pressure. In contrast, a stock with a large float is less likely to experience large price swings, as there are more shares available to trade.

In conclusion, understanding mean reversion, market balance, and the impact of a stock’s float is crucial for investors to make informed decisions and mitigate risks in the financial markets. By keeping these concepts in mind, investors can better navigate market cycles and position themselves for long-term success.